MauledAgain

Prof. James Edward Maule's more than occasional commentary on tax law, legal education, the First Amendment, religion, and law generally, with sporadic attempts to connect all of this to genealogy, theology, music, model trains, and chocolate chip cookies. Copyright 2004-2019 James Edward Maule.

Friday, July 29, 2016

Subject to Tax? Yes and No

There are many reasons why taxation is confusing. One of those many reasons is the willingness of legislatures to exempt someone from one tax but to subject that same person to a very similar tax. A recent case, Curet v. Comr., T.C. Memo 2016-138, illustrates this “principle of confusion” in the context of a Puerto Rico resident.

The taxpayer lived and worked in Puerto Rico during 2010. He was self-employed. For 2010, he filed Form 482.0, Individual Income Tax Return, with the Commonwealth of Puerto Rico. With the return he included a Schedule M, Professions and Commissions Income, which is the equivalent of the Schedule C, Profit or Loss From Business, on the federal Form 1040. He reported a profit on that Schedule. He did not file a Form 1040-SS, U.S. Self-Employment Tax Return with the IRS for 2010. On April 28, 2014, the IRS issued a notice of deficiency, asserting that the taxpayer owed self-employment tax on the profit from the business generating the profit on the Schedule M.

The Tax Court explained that although citizens and residents of the United States are subject to federal income taxation on taxable income no matter its geographical source, under section 933(1) a taxpayer who is a resident of Puerto Rico for the entire taxable year is not taxed on items of income from sources within Puerto Rico, other than compensation for services provided as an employee of the federal government. However, though that exemption applies to the income tax, under section 1401 and Regulations section 1.1402(a)-9, it does not apply to the self-employment tax. In other words, residents of Puerto Rico must compute net earnings from self-employment in the same manner as do residents of the United States.

The taxpayer argued that he was not subject to any federal tax for 2010 because he was a resident of Puerto Rico. That argument, unfortunately for the taxpayer, had to be rejected because it was in total conflict with the law. Yet it is understandable how someone, seeing the exemption in section 933(1), or, as is more likely, reading something along the lines of “Residents of Puerto Rico are not subject to U.S. taxation,” could conclude that they had no obligation to file either an income tax or self-employment tax return with the IRS. In fact, the taxpayer claimed he had reached this conclusion after consulting a Puerto Rico tax adviser. But because the adviser did not testify at the trial and because the taxpayer did not establish that the adviser was a competent professional with sufficient expertise to justify reliance, that the adviser was given necessary information from the taxpayer, and that the taxpayer actually relied on the adviser, the Tax Court concluded that there was no reasonable cause to avoid the penalties under section 6651(a)(1) and (2) for failure to file the return and failure to pay the tax.

The self-employment tax applies to residents of Puerto Rico because they are included in the social security system. The income tax does not, because the tax is remitted to the Commonwealth of Puerto Rico rather than to the Treasury Department. The distinction is logical. But it is confusing for those who are not focused on the subtle and precise nuances of tax law. If, in fact, the taxpayer had consulted a tax adviser, it is even more unfortunate that the taxpayer was led astray. A confused tax adviser is of little help for a confused taxpayer.

Wednesday, July 27, 2016

How Not to Help Your Tax Return Preparer

A recent Tax Court case, Probandt v. Comr., T.C. Memo 2016-135, presents a good example of how not to help your tax return preparer. The taxpayer earned a degree in business administration in the mid 1970s, and then worked for an accounting firm and later for a public company auditing financial statements. During the 1980s he worked for a securities brokerage firm and in the early 1990s worked at two money management firms managing investments. In 1995 or 1996 he began investing for his own account, and a few years later, along with several other individuals, acquired A&G Precision Parts. The taxpayer was a 20 percent partner, the managing partner, and the tax matters partner. During 2001 and 2002, the taxpayer explored business opportunities in China, separate and apart from the A&G operations.

For 2001 and 2002, A&G filed federal partnership income tax returns, which the taxpayer signed as tax matters partner. The returns were prepared by a CPA. A schedule K-1 was issued to the taxpayer for each of those years. The 2001 schedule K-1 reported $81,322 as his distributive share of ordinary income, $135,000 in guaranteed payments, $125,000 in cash distributions, and nondeductible expenses of $1,067. The 2002 s K-1 reported $234,067 as his distributive share of ordinary income, $145,000 in guaranteed payments, $25,000 in cash distributions, and nondeductible expenses of $2,055. The taxpayer received his Schedules K-1 before filing his individual federal income tax returns for 2001 and 2002.

The taxpayer filed delinquent federal income tax returns for 2001 and 2002 on April 10, 2004. The returns were prepared by a CPA. The taxpayer did not provide the CPA with copies of his 2001 and 2002 schedules K-1. Instead, the taxpayer provided the CPA with summary sheets of his travel, meals and entertainment, printing, and consulting expenses derived from his handwritten records. A schedule C was attached to the taxpayer’s 2001 return. It listed the principal business of the proprietorship as “Investments”. The entry for the business name was left blank, and the address reported for the business was the same address reported for one of A&G’s other partners his schedules K-1 for 2001 and 2002. The 2001 schedule C reported gross receipts of $231,000 and total expenses of $201,400 for a net profit of $29,600. A similar Schedule C, with an identical principal business and address and with no entry for the business name, was attached to the taxpayer’s 2002 return. The 2002 schedule C reported gross receipts of $201,900 and total expenses of $194,000 for a net profit of $7,900. No schedule E was included in the 2001 or 2002 return, and no partnership income was reported on those returns. The IRS issued a notice of deficiency, including, among other items, increases in the taxpayer’s income for those two years on account of the distributive shares and guaranteed payments from the A&G Partnership.

The IRS took the position that the income reported on the schedules C for 2001 and 2002 were from a business of the taxpayer separate from the partnership. The taxpayer explained that the amounts reported on the schedules C were the amounts from the partnership, except that he “mistakenly believed that he was required to report only the cash he received from A&G each year.” According to the taxpayer, this consisted of the guaranteed payment plus the cash distribution. The taxpayer also contended that he had no income from any other business in those years.

The Tax Court compared the sum of the taxpayer’s guaranteed payment and cash distribution for 2001 with the amount reported on the schedule C for that year, and noted that the latter was $29,000 less than the former. The taxpayer’s explanation was that $30,000 of the cash distribution was a disbursement from the partnership to buy used equipment for it, and when that failed to materialize, in 2002 it was agreed he could keep the $30,000 because cash distributions were low that year. Thus, the partnership’s CPA treated it as part of the 2002 guaranteed payment, and it was reported in 2002. The other $1,000 was described as “most likely small sums received from A&G for miscellaneous items.” The partnership’s president and operations manager corroborated the taxpayer’s testimony concerning the $30,000.

The Tax Court compared the sum of the taxpayer’s guaranteed payment and cash distribution for 2002 with the amount reported on the schedule C for that year, and noted that the latter was $31,900 more than the former. Of that difference, $30,000 reflected the 2001 disbursement treated as 2002 guaranteed payment, and the other $1,900 was described as “little checks” received from the partnership for miscellaneous items.

The Tax Court concluded that “the near match of the Schedule K-1 items that represent A&G’s cash disbursements to [the taxpayer] and the gross receipts he
reported on Schedules C for 2001 and 2002 is too close to be mere coincidence.” Further, though the taxpayer’s understanding of partnership taxation was incorrect, “his belief that he needed to report only cash distributions he received from the partnership and not undistributed partnership income was plausible.” It also concluded that there was no evidence of income arising from other business operations, and no evidence of bank deposits or spending in excess of reported income, to justify treating the amounts reported on schedule C as anything other than the partnership items.

After dealing with burden of proof issues, the Tax Court held that because the taxpayer conceded he failed to report properly his income from the partnership, a redetermination was necessary. It concluded that the taxpayer overstated income in 2001, and understated income in 2002. The Tax Court also resolved other issues not involving how the taxpayer reported income from the partnership.

Though the taxpayer was not a tax return preparer nor a CPA, the taxpayer did have a business education and experience with financial statements, investments, and business operations. The sensible and prudent thing to do is to turn over to the CPA all tax-related information, including schedules K-1. Either the CPA did not ask if there were any schedules K-1, or, having asked, was told, incorrectly, that there were none. The taxpayer and his partners acquired A&G in 1998, so presumably the taxpayer’s returns for 1998 through 2000 contained schedules K-1. If the same CPA prepared those returns, the CPA should have asked why there were no schedules K-1 for 2001 and 2002. If the CPA was a newly retained preparer, the question should have been a request for prior year returns.

Though it is not possible to determine where the breakdown occurred, and perhaps the CPA could have helped the taxpayer avoid at least some of his audit and litigation troubles, the most likely reason for the problem was the taxpayer’s lack of care in dealing with tax and business documents. That conclusion is supported by the fact that the taxpayer also failed to report dividend and interest income. Conversations with tax return preparers often include stories about clients and how they make the preparer’s job more difficult. This case is an instance in which the taxpayer didn’t necessarily make the preparer’s job more difficult, but made the taxpayer’s own life far more aggravating than it needed to be.

Monday, July 25, 2016

What to Do With Fireworks Excise Tax Revenues?

Usually, taxes are enacted or increased to provide funds for specific purposes or to provide resources for general funds used for a package of government services. Occasionally, a tax is enacted to discourage particular behavior, with the expected revenue earmarked for specific purposes related to the undesired behavior, or added to the general fund. What is unusual is the enactment of a tax on behavior that boosts local economies, with the use of the tax revenues deferred until the voters decide.

According to this story, when Georgia legalizes the sale of fireworks, it enacted an excise tax. Instead of specifying where the revenue from the tax would be used, the legislature authorized a vote on a constitutional amendment allocating 55 percent of the revenue to the Georgia Trauma Care Network Commission, 40 percent to the Georgia Firefighter Standards and Training Council, and 5 percent to local 911 systems. It is unclear what happens if the referendum fails. Presumably, another vote would be authorized, either with different percentage allocations or revised recipients of the tax revenues.

One problem I have with this approach is the commitment to enacting the tax before the use of the revenues are decided is that those voting on whether to enact the tax are being asked to make a decision without having all of the facts. The purposes for which the tax revenues are used are factors relevant to deciding whether to support enactment of the tax.

Another problem I have with this approach is that it shuts down voter opportunity to make choices other than those in the proposed referendum. What if voters want a different percentage allocation? What if they want other organizations or programs to receive some or all of the tax revenues? Under this approach, they vote down the proposal, a replacement is designed, another vote takes place, and time is wasted. Would it not have made more sense to offer a referendum to the voters before the tax is enacted, with a multiple-choice list that includes write-in suggestions? Modern technology makes this path as easy as an online survey.

A related problem is that the proposed recipients listed in the referendum are worthy causes. Voting against the referendum seems callous. Yet there are other worthy causes that perhaps should be included. Voting for the referendum suggests that those causes are not as worthy.

What would I do with the tax revenue? At least some of it would be funneled into a program that isn’t on the ballot, that is no less connected to fireworks sales and use, and that is no less worthy than the three programs on the ballot. I base my suggestion on the many news stories that have appeared in recent years. Why not use at least some of the revenue from an excise tax on fireworks sales to fund programs in the K-12 education system, and programs aimed at adults, that teach the safe and proper use of fireworks?

Is it because cigars do not pose the health hazards and eventual burden on health care costs that cigarettes and other tobacco products do? Of course not, though at least one now-prominent politician seems to think, or perhaps is paid to say, that smoking does not cause cancer or death.

Is it because cigar manufacturing occurs in Pennsylvania? That’s what legislators provide as an explanation, describing the industry as “thriving.” That explanation is facetious. First, the cigar manufacturing industry in Pennsylvania employs roughly 1,000 people. That’s far from the tens of thousands employed in the health care sector, in education, in the hospitality industry, in the financial services industry, and in pretty much every other employment sector, and barely registers in economic statistics for the state. Second, because every other state but one treats cigars as being made of tobacco and thus subject to the tobacco tax, Pennsylvania manufacturers have nowhere to go, and there’s no guarantee that relocating to that one state would be an economically sound decision.

Is it because the cigar manufacturing industry does a good job “lobbying” Pennsylvania legislators? Of course. There are 34 lobbyists in the state capital advocating for the cigar manufacturing industry, which consists primarily of four companies. One company has spent $1.8 million on lobbying during the past two years. That apparently does not include campaign contributions. It also apparently does not include political contributions from individuals who are executives with the cigar companies. Perhaps it would be cheaper to pay the tax and skip the cost of avoiding the tax?

Is it because many state legislators like to smoke cigars? That claim has been made, though a reliable head count of cigar-smoking Pennsylvania politicians does not seem to exist. The claim also seems suspect because chewing tobacco is not exempt, and allegedly there are more than a few tobacco-chewing legislators. Perhaps the state needs a study to determine if there exists a connection between tobacco ingestion and inefficiency in legislation.

The problem with the “logic” advanced by the supporters of exempting cigars from the tobacco tax is that on closer examination it isn’t logic. If taxes cause jobs to leave, then why do jobs continue to exist in Pennsylvania? Have the stores selling cigarettes and chewing tobacco closed their doors? Have the employees paying income tax all fled to Wyoming? Have the hotels subject to room taxes shut down? The job preservation argument is, like the related job creation through tax cuts for the wealthy argument, total nonsense.

Worse, if the justification for the tobacco tax is to discourage behavior that is harmful not only to the user of tobacco but also to those afflicted with second-hand smoke and disadvantaged by the harmful effect of tobacco use on the health care system, why exempt cigars? Why encourage smokers to shift from cigarettes to cigars? Why not extend similar exempt status for other “sin taxes” where those activities create jobs? The dealing of illegal drugs is a “thriving” business in Pennsylvania, surely generating jobs and income for far more than 1,000 people, so should it be exempt from taxation?

Wednesday, July 20, 2016

The Tax Break Parade Continues and We’re Not Invited

There’s a parade underway. Unlike most performances, in which those watching pay and those performing are paid, this parade is special. Those who are being paid aren’t putting on much of a performance, and almost none of those being charged are getting to watch anything. Those who make an effort to look closely might see something, and that is the continuation of income, sales, property, and other tax dollars collected from the poor and middle class being transferred to a long list of highly profitable businesses and corporations.

Actually, there are many of these parades. Almost every state has one. The tax break parade that gets my attention is the one in New Jersey. Here is a list of some of those who have had their reached-out fists filled with taxpayer funds:

Now comes a report that yet another economically successful corporation has jumped in. American Water has been promised $164 million in taxpayer dollars to reward it for moving its headquarters from Vorhees, New Jersey, to Camden, New Jersey. There is no indication that this move will create jobs for Camden residents or in any other way benefit that city. Although the program under which tax dollar are handed over to private sector companies was advertised as one that would help the city of Camden, in practical reality it is nothing more than the relocating of existing jobs at public expense. In When Those Who Hate Takers Take Tax Revenue, I wrote:

One of the arguments put forth by the anti-government-spending folks is that it is bad morally, socially, and politically to collect taxes from one group and to disburse the receipts to another group. These folks like to brand the first group as “makers” and the second group as “takers.” Yet when the takers are their friends and allies in the movement to feudalize America, not a peep is heard from them.

New Jersey, governed by a member of the political party that is trying to consolidate its power by demonizing “takers,” provides an excellent example of the hypocrisy entrenched in this modern reverse Robin Hood philosophy. * * *

Though this tax revenue giveaway game has been underway for several years, there is no sign that the economic condition of Camden’s residents have improved. The folks in Trenton who rail against government spending cut education spending, job training spending, social welfare assistance, and a variety of other expenditures denounced as enabling “takers” to feed at the public trough. Yet in the meantime, a state that faces deficits in its transportation infrastructure budget continues to funnel taxpayer dollars into the hands of companies with sufficient political connections to snag some funds for themselves. * * *

At what point will enough voters see through the con game and send packing the takers who took over political control by demonizing takers? When will political hypocrisy disappear? At what point will people realize that economic growth consists of creating something of economic value and not simply moving jobs from one place to another?

There’s something not quite right in the collective psyche of the anti-government-spending crowd. Enraged by high taxes, they manage to put into office, and keep in office, people who dish out tax revenues as though there were no limits on taxation. Of course, the tax breaks go to those who are in least need of economic assistance. Their excuse, that they will use the tax breaks to help those in need, is hilarious, because the best way to help those in need is to direct assistance directly to them so that they can infuse those dollars into the economy. That makes the economy grow. Handing tax dollars to those who don’t need financial assistance is nothing more than helping some people grow their Swiss bank stash.

When people complain about the sad state of the nation’s economy, rarely is this tax break parade brought to their attention. Instead, all other sorts of distractions are put in front of their eyes so that the tax break parade passes by almost silently. It’s always much easier to feel smug about not inviting someone to a parade if that person is unaware that the parade exists.

Monday, July 18, 2016

Move In Together, Buy a House, Beware of the Tax Consequences

A recent Tax Court case, Jackson v. Comr., T.C. Summ. Op. 2016-33, demonstrates why couples who decide to live together in a house that they purchase need to be scrupulous about keeping records that proves there is a co-ownership between them. The outcome of the decision probably came as a surprise to the taxpayer.

The taxpayer lived with his girlfriend in a house she purchased in 2005. She financed the purchase with a loan provided by a third party bank. Because the taxpayer’s financial problems precluded including him on the loan, his girlfriend was listed as sole owner on the deed and as the only debtor on the loan secured by a mortgage on the property. The taxpayer testified that each month he transferred $1,000 in cash to his girlfriend to make “interest-only” payments on the loan. He paid in cash to avoid bank fees, but did not submit any evidence, such as receipts, to prove he made those payments. He did produce a copy of a letter from his girlfriend, addressed to the IRS, in which she stated that the taxpayer had paid her $1,000 each month for the past ten years. The taxpayer testified that his girlfriend paid the real property taxes and the homeowner insurance premiums. He also testified that he and his girlfriend shared maintenance costs.

When the taxpayer filed his federal income tax returns, he deducted mortgage interest of $15,720. It is not clear how $1,000 a month for 12 months works out to $15,720. The IRS disallowed the deduction, and the taxpayer petitioned the Tax Court for a redetermination of the IRS notice of deficiency.

Interest on a debt is deductible by a taxpayer only if the debt is an obligation of the taxpayer and not an obligation of someone else. Under regulations section 1.163-1(b), interest paid by a taxpayer on a mortgage loan secured by real estate of which the taxpayer is a legal or equitable owner is deductible even if the taxpayer not directly liable on the bond or note secured by the mortgage. The Tax Court treated the loan in question as acquisition indebtedness on a qualified residence for purposes of analyzing the issue facing it.

Thus, the taxpayer was required to show that he had legal, equitable, or beneficial ownership in the residence. To achieve this, the taxpayer argued that he and his girlfriend were domestic partners and thus shared equal ownership of the residence. Thus, for example, in Uslu v. Comr., T.C. Memo 1997-551, the taxpayer, unable to obtain financing because of a recent bankruptcy, was treated as an equitable owner of property financed by a loan obtained by his brother because the taxpayer and his brother agreed that the taxpayer would pay the mortgage and all expenses for maintenance and improvement. The key is that the taxpayer made himself legally obligated to pay the mortgage.

The Tax Court upheld the IRS determination because the taxpayer did not have a legal obligation to make mortgage payments, and did not hold legal title to the property. The court explained that whether a taxpayer has equitable or beneficial title depends on whether the taxpayer has the right to possess the property and to enjoy its use, rents, or profits, has a duty to maintain the
Property, is responsible for insuring the property, bears the property’s risk of loss, is obligated to pay the property’s taxes, assessments, or charges, has the right to improve the property without the owner’s consent, and has the right to obtain legal title at any time by paying the balance of the purchase price. The Tax Court noted that the taxpayer did not produce any evidence that he made the monthly payments he claimed to have made, dismissing the girlfriend’s letter as deserving no weight. He did not pay taxes or insurance premiums. There was no evidence he could make improvements to the property without his girlfriend’s consent. There was no evidence that he could obtain legal title by paying the balance due on the mortgage. There was no evidence of any agreement between the taxpayer and his girlfriend with respect to the ownership and use of the residence. Though the girlfriend’s testimony would have been relevant to some of these issues, she did not appear as a witness in the case.

The lessons that this case presents to cohabiting taxpayers is obvious. First, just as people about to marry should enter into pre-marital agreements, so, too, people about to cohabit should enter into agreements that address issues such as ownership and financial responsibilities with respect to the residence in which they plan to live. Second, transfers between the cohabiting couple that are relevant to the ownership and use of the residence need to be memorialized in some manner so that when questions arise in the future, the taxpayers can produce the requisite proof of what they claim took place.

A recent development provides yet another example of how tax ignorance is dangerous. This time, scammers are calling people, claiming to be the IRS, and demanding payment of a “federal student tax.” The scam has been so successful that colleges and universities are notifying students, and in some instances, recent graduates, informing them of the scam and the need to refrain from sending money to someone who is not an IRS representative. Perhaps these schools should have required their students to understand tax basics before sending them out into the world. I’m not advocating mandating the study of complex computations and statutory detail. I’m suggesting that students learn some general principles, not unlike what would be covered in the first few classes of a law or business school taxation course.

It saddens me when I hear or read of someone forking over cash, a credit card number, or a prepaid debit card because they did not have the opportunity to learn enough to protect themselves from the likes of despicable scammers. By the time the word gets out, and gets circulated, thousands or tens of thousands of victims have dished out funds to scammers who use those funds for all sorts of purposes, most of which are far from noble.

Wednesday, July 13, 2016

When Tax and User Fee Increases Cost Less Than Tax Cuts and Tax Freezes

One of the flaws in the anti-tax philosophy is the tendency of emotions to override rationality. “They want to raise our taxes” becomes a rallying cry because tax increases are, emotionally, an undesirable event. Yet with a bit of careful reasoning, it sometimes turns out that the alternative to a tax freeze, or tax cut, is far worse. The emotional reaction at that point comes too late.

For many years I have argued that the long-term financial cost, to individual taxpayers, of avoiding tax increases and even cutting taxes, is far greater than the paltry savings conferred on 99 percent of taxpayers when taxes are frozen or cut. My favorite example involves potholes. It’s an easy example, in part because almost everyone dislikes potholes. Perhaps the people who make money from potholes, such as front-end alignment shops, wheel and tire manufacturers, and tow truck operators, like potholes, but I suspect that they, too, aren’t particularly enamored of them. I’m confident that they aren’t singing the praises of potholes if one of their relatives or friends is killed or injured on account of a pothole. I described one such incident in When Tax Cuts Matter More Than Pothole Repair, and that was just one out of tens of thousands. Opponents of tax or user fee increases to fund pothole repairs argue that the money should come from other spending, and yet, as I described in Funding Pothole Repairs With Spending Cuts? Really?, when that idea was floated in Michigan, poll respondents objected to cuts being made in education, health care, public safety, and every other program. These respondents understood that fixing potholes at the expense of other outlays simply shifted the problem to the back burner.

As I have repeatedly pointed out, potholes are a financial imposition on taxpayers. Though not every taxpayer is directly affected by potholes, over a period of years, most are. At some point, almost every taxpayer will be saddled with the cost of new tires, new wheels, new shock absorbers, new catalytic converters, replacements for air bags and other vehicle parts, front-end alignments, accidents, injuries, and death. I wonder if anyone who, after hitting a pothole and careening off the road in the direction of a tree or telephone pole, thought, “Perhaps opposing a tax increase for pothole repair wasn’t such a good idea.”

The facts are indisputable. As I described in Potholes: Poster Children for Why Tax Increases Save Money, I related a report from the United Kingdom revealing that one-third of drivers had suffered damage to their vehicles caused by potholes. I described a report out of Los Angeles explaining that potholes cause an average of $750 each year for car repairs for each driver, and yet some people objected to paying an additional $35 each year to fix potholes. The suppression of rationality by emotion, a disease that has swept with virulence throughout the nation, is starkly evident in that anti-tax reaction.

Now comes news, in a report from several months ago shared by one of my readers, that drivers in this country are paying $6.4 billion annually in car repairs due to potholes. In addition to those costs, there are the indirect costs of detours, traffic congestion, increased travel time, and increased transportation and shipping expenses borne by businesses. On top of that are the costs of injuries and deaths. The report, citing a Bankrate.com survey, points out that 63 percent of Americans have less than $1,000 in spare cash on hand to deal with financial emergencies. In other words, more than half of the people who incur pothole damage are in a financial bind when it comes to dealing with the consequences. The report selected Alabama as an example of the problem. In Alabama, 18.6 percent of the population lives below the poverty line, the roads in Birmingham were ranked 20th worst among cities with a population of 500,000 or more, and 43 percent of that city’s streets are in poor condition. Each Alabama driver incurs more than $1,200 annually due to higher vehicle operating costs, accidents, and delays on account of damaged roads.

It was a little more than a year ago, in Battle Over Highway Infrastructure Taxation Heats Up in Alabama, that I pointed out the absurdity of tax increase opposition in a state desperately in need of a solution to a serious problem. When the governor proposed raising taxes to fund deficits in the transportation budget, Republican state senator Bill Holtzclaw rented a billboard to proclaim, “Governor Bentley wants to raise your taxes. I will not let that happen. Semper Fi - Senator Bill Holtzclaw." So the state Department of Transportation suspended funding for highway projects in Holtzclaw’s district. Who suffers? Just the people who voted for him? Hardly. It’s an sad example of how politics in this nation have sunk into the pit of emotionality. Surely the people of Alabama, given a choice between paying an additional $50 or $100 per year to fix the state’s highways or continuing to shell out $1,200 per year in pothole damage costs, would choose the former, provided they could get past the emotions stirred up by the anti-tax crowd. If a tax increase puts $1,100 in motorists’ pockets, then it’s a giving and not a taking.

Monday, July 11, 2016

Disallowance of Deduction for Law School Tuition Affirmed

Law school tuition is expensive. Claiming it as an income tax deduction reduces the financial burden on the taxpayer. The difficulty is that, aside from a very rare instance unique to California, law school tuition is not deductible. That, however, does not stop taxpayers from trying to fashion arguments to squeeze past the no-deduction barrier. In a recent decision, O’Connor and Tracy v. Comr., the Court of Appeals for the Tenth Circuit affirmed a Tax Court decision rejecting arguments made by a married couple seeking to deduct law school tuition paid for the husband.

The husband, a United States citizen, studied law in Germany. He completed the minimum requirements to be a lawyer in Germany in June 2007 and was licensed to practice as an attorney, civil servant, or judge. He finished those requirements while living in Utah. In 2007 he took over project management of a residential building project in Salt Lake City. In 2009, he entered law school in San Diego. During 2010 and 2011, he was not employed nor did he report any self-employment income. He earned his J.D. degree in 2012, and passed the New York bar examination in 2014. At some point during this time period, he became involved in investigating a qui tam action, and filed a qui tam complaint in September 2014.

The taxpayers deducted the tuition and other costs of the husband’s J.D. law studies. The IRS disallowed the deductions and issued a notice of deficiency. The taxpayers filed a petition in the Tax Court, and argued that because the husband had fulfilled the requirement to practice law in Germany, he had met the minimum requirements of being a legal professionals and thus was entitled to deduct the expenses. They contended that the minimum requirements were met because he could have been licensed in New York without earning a J.D. degree. They argued that he was carrying on a trade or business because of his involvement with the project management and the qui tam action.

The Tax Court upheld the disallowance of the deductions. It concluded that the husband was not established in the legal profession in the United States, making his J.D. education expenses incurred in connection with entering a new trade or business. It also concluded that even if the husband’s involvement with project management and the qui tam action existed in 2010 and 2011, he had not shown they were connected with the law school education. The taxpayers appealed to the Tenth Circuit.

The taxpayers argued that the Tax Court erred by relying on theories that the IRS had not included in the notice of deficiency. The Court of Appeals concluded that although the “new trade or business” theory was not explicitly raised in the notice of deficiency, the Tax Court is not limited to theories in the notice of deficiency and is permitted to apply the correct law to the facts. The Court of Appeals noted that in many previous cases the Tax Court allowed the IRS to raise new theories even when Tax Court proceedings were well underway. When the IRS raises a new theory, taxpayers must demonstrate surprise and disadvantage as a prerequisite to blocking IRS reliance on the theory, but the Court of Appeals concluded that the taxpayers had not only failed to demonstrate surprise and disadvantage, they had recognized the “new trade or business issue” when they addressed it in their amended 2010 return.

The taxpayers argued that the Tax Court defined the term “legal professional” too narrowly, pointing out that the husband was “active in both creating a new business model based upon his acquired knowledge of the [German Civil Code] and German construction standards as well as qui tam litigation.” The Court of Appeals noted that the argument was based largely on facts not before the Tax Court. It also noted that a long line of cases and rulings have concluded that that a person licensed to practice law in one jurisdiction and who incurs expenses to be admitted in another jurisdiction is considered to be entering a new trade or business.

The taxpayers argued that the Tax Court improperly required them to show a nexus between the J.D. education expenses and the husband’s business activities. The Court of Appeals dismissed the argument as making “little sense,” because the primary requirement for a deduction is that the expense be an ordinary and necessary expense bearing a proximate and direct relationship to the taxpayer’s trade or business. The taxpayers’ complaint that the Tax Court improperly imposed an “additional temporal requirement” was rejected because the Tax Court assumed that the husband was engaged in the activities in question during the years in issue even though there was no evidence that he did so.

The Court of Appeals upheld the accuracy-related penalties imposed on the taxpayers. The court noted that the facts were very similar to a 45-year-old case denying a deduction for law school expenses by a taxpayer who earned a law degree in Poland, practiced law in Poland, earned a law degree in Germany, moved to Ohio, earned a law degree in Ohio, was admitted to the Ohio bar, and practiced law in Ohio. The Court of Appeals rejected the taxpayers’ attempt to distinguish that case, and that the Tax Court was correct in concluding that the husband had failed to heed relevant precedent.

The list of cases in which deductions for law school tuition and related expenses have been disallowed is very long. It now is longer. Yet surely as the sun rises in the east, someone else will end up adding a case to that list. And almost certainly it will be a lawyer.

Friday, July 08, 2016

Taxes for Revenue and Taxes for Behavior Modification

Readers of MauledAgain know that I am not a fan of using tax systems to encourage or discourage behavior. Advocates of behavior-focused taxes claim that imposing taxes on unwanted behavior and giving tax breaks for desired behavior pushes and pulls society into a better place. In theory, these taxes ought to work as advertised. In practice, sometimes they do, and sometimes they don’t. In theory, taxes designed to discourage behavior generate no revenue if the taxes succeed in ending the undesired behavior.

A recent article about taxes on disposable plastic shopping bags points out the mixed results that those taxes generate. These taxes are designed, not to raise revenue, but to reduce the adverse impact of the bags. Aside from filling landfill and creating litter, these bags also endanger wildlife and habitats. Montgomery County, Maryland, enacted a nickel-per-bag tax in 2012. Revenue from the tax grew 3.2 percent from fiscal 2014 to fiscal 2015. Why? In part because the population increased and in part because people made more shopping trips thanks to an improving economy. But part of the increase is attributable to grocery stores handing out more disposable bags. This is not what county officials had expected. Even more puzzling, the number of disposable bags handed out by convenience stores, pharmacies, and department stores decreased. And reports from environmental field workers disclose that the number of plastic bags caught in stream traps dropped roughly 10 percent from 2011 to 2015. The District of Columbia also enacted a nickel-per-bag tax, in 2010. It, too, reports a growth in revenue from the tax and a decrease in the number of bags found in the stream traps.

What’s the alternative? One possibility is to prohibit the undesired behavior. For example, several localities on the West Coast, simply ban the use of disposable bags. What’s the drawback to this approach, aside from the claims that liberty assures all people the right to do whatever they want to do without limits? Enforcement of the ban is more expensive than imposing a tax, because part of the administrative burden of imposing of the tax falls on merchants. Would fines and penalties imposed on violators of the ban raises as much revenue as would a tax? I don’t know. If the goal of the tax is not to raise revenue, then the question of whether fines and penalties would raise revenue in lieu of the tax makes no sense, because revenue supposedly is irrelevant.

I suspect that revenue is, in fact, a goal. Why? Legislators know that it is impossible to bring a total end to undesired behavior. The nation’s unfortunate flirtation with Prohibition demonstrated that outright bans on alcohol did not stop people from drinking alcohol. Taxes on alcohol have not prevented sales of alcoholic beverages from growing over the years. So, if an undesired behavior is a sure thing, imposing a tax on it guarantees revenue.

Wednesday, July 06, 2016

A Not So Hidden Tax Increase?

When a person lives in one state and works in another, the usual pattern is for the state of residence to require the person to compute an income tax based on all of the person’s income, and then to provide a credit for income taxes imposed by the other state on the income earned by that person in the other state. The credit is limited to the amount of income tax that the state of residence would impose on the income earned in the other state. To use a simple example, suppose X lives in State 1 and works in State 2. Suppose X’s only income is a $50,000 salary earned in State 2. Suppose State 2 imposes a $5,000 income tax on the salary. Suppose State 1 has a flat 3 percent income tax. X would compute a $1,500 income tax in State 1, but would then be permitted a credit not to exceed $1,500. In this example, X would not pay any tax to State 1.

In some instances, states enter into reciprocal agreements. Under these agreements the each state agrees not to tax the income earned within its borders by someone resident in the other state. The purpose of these agreements is twofold. First, it eliminates the complexity of computing the credit, something that often is much more intricate than demonstrated in the simple example above. Second, it shifts revenue so that taxpayers are paying income tax to their state of residence. How that works out in terms of revenue shifting depends on the numbers.

Now comes news that New Jersey’s Governor Christie has instructed state officials to examine and report to him on the possibility of withdrawing from the reciprocal income tax agreement that exists between New Jersey and Pennsylvania. New Jersey officials estimate that the income tax they would collect from Pennsylvania residents working in New Jersey would “far outweigh” the taxes New Jersey collects on New Jersey residents working in Pennsylvania. Because Pennsylvania has a flat 3.07 percent rate and New Jersey has a progressive system with rates ranging from 1.4 percent to 8.97 percent, the impact on residents of each state working in the other state will vary. Pennsylvanians working in New Jersey for higher salaries will pay more tax because they will pay at New Jersey’s higher rates, and the Pennsylvania credit will be limited to Pennsylvania’s 3.07 percent rate. Pennsylvanians working in New Jersey for lower salaries will pay New Jersey income tax but then receive a Pennsylvania credit, leaving them with the same tax liability they otherwise would have had. New Jersey residents working in Pennsylvania for higher salaries will not pay more taxes, because they will receive a credit for the taxes paid to Pennsylvania. But New Jersey residents working in Pennsylvania for lower salaries will end up paying more taxes, because the credit for taxes paid to Pennsylvania will be limited to the lower tax paid to New Jersey. For example, a New Jersey resident earning $20,000 in Pennsylvania currently is not taxed in Pennsylvania. Ignoring deductions and assuming no other income, this person would have a $280 New Jersey income tax liability. If the reciprocal agreement is terminated, this person will be taxed in Pennsylvania in the amount of $614, will compute a New Jersey tax of $280, and will claim a credit of $614 limited to $280. This person will end up with a $334 income tax increase.

According to this graphic, roughly 100,000 south Jersey residents work in the southeastern Pennsylvania area. I did not try to figure out how many other New Jersey residents work in other parts of Pennsylvania. Roughly 40,000 southeastern Pennsylvania residents work in south Jersey. Again, I did not try to determine how many other Pennsylvanians work in New Jersey. The point is, Christie’s proposal would affect far more than a few people.

Fourteen years ago, another New Jersey governor floated a proposal to end the agreement. Opposition was rapid and strong. The agreement survived. What will happen this time if Christie decides to move forward with his proposal? Yes, there will be opposition. Will it succeed? We’ll find out soon enough.

Here and there across the nation, a few state governments have started examining the advantages and disadvantages of the mileage-based road fee. One state, Oregon, has gone so far as to implement a pilot program, to see how a theory works when confronted with practical reality. In the east, the I-95 Corridor Coalition, a multi-state group examining the possibilities for maintaining and improving one of the nation’s busiest and most essential interstate highways, has been looking at possibilities. Recently, it applied to the Department of Transportation for grant money to be used to set up a pilot program. The Coalition wants to study how mileage-based road fees could be computed in the I-95 corridor.

Then, according to this story, some Republicans in the Connecticut legislature got wind of the grant application. Immediately, they accused the state’s governor of “planning a new tax.” Their claims demonstrate what happens when emotions trump logic and reasoning. According to state senator Toni Boucher, the supposed new tax “will hit drivers every day.” She continued, “It will hit you everywhere you go, even if you are driving to a hospital emergency room.” Did it ever occur to Boucher that the existing liquid fuels tax hits drivers every day? Did it occur to her that the existing liquid fuels tax applies when someone is driving to an emergency room? Did it occur to Boucher that the existing tax is insufficient to maintain Connecticut’s highways? I’ve driven in Connecticut enough times to realize the inadequacies of I-95 as it passes through Connecticut, though in all fairness the same problem exists for I-95 in other states as well. Potholes abound. With exits and entrances every mile or so, particularly in the western part of the state, increased traffic volume poses risks that need remediation, and remediation requires money. Connecticut needs at least $100 billion to fix its failing transportation infrastructure.

Boucher and her anti-tax colleagues also fail to understand that Connecticut taxpayers are financing the cost of providing highways for nonresidents who travel through the state, especially those who do not stop and patronize Connecticut businesses. There are no toll roads in Connecticut, perhaps another indication that somehow, some way, magically, highways will appear and take care of themselves without anyone being “hit” by a tax, fee, or other charge, ever.

The fact that the grant being sought by the interstate coalition is nothing more than money for learning about the mileage-based road fee doesn’t matter to the anti-tax crowd. Opposition to funding this grant is nothing more than opposition to education. It does not surprise me that anti-tax and anti-education efforts are political comrades, if not one collective.

Another Republican legislator, state senator Fasano, claims that “More taxes and more burdens on Connecticut drivers is not the way to improve transportation in our state.” Then what is the way, senator? Taxes on milk? Slave labor? Pretense that potholes don’t exist? Deporting half the population and thus cutting down on traffic congestion? Walls at the border so that nonresidents of Connecticut cannot use Connecticut highways? What wonderful plan do you have to fix the problem? Criticizing everyone else is not a plan. It’s an indication that you have no plan, other than to appeal to the basic selfishness of drivers who want free highways and think someone else is going to pay for them. It’s an appeal for support from “takers not makers” who you claim to despise.

The anti-tax crowd claims that the mileage-based road fee is unpopular. It is. Every tax, every fee, every purchase price is unpopular. That’s human nature. What overcomes the baser instinct is education. Once people understand that a mileage-based road fee reduces what is paid by those who drive relatively less and shifts the burden to those who are using and burdening highways disproportionately more than what they are paying, they will realize that the mileage-based road fee is exactly what solves one piece of the “taker not maker” syndrome they so detest.

If the anti-tax crowd had their way, there would be no taxes. But then there would be no highways, or police, or anything else. Or there would be corporate-owned highways, corporate-owned police, and corporate-owned everything else, dictated by the oligarchy and impervious to the voting booth. Once we reach that point, surely most of the people sucked into the anti-tax movement will realize it was nothing more than a front for oligarchic takeover of public services, and they’ll be screaming for the do-over or reset button. Unfortunately, in much of life, there is no reset button.

Friday, July 01, 2016

Defining Metropolitan Area for Tax Purposes

A recent Tax Court case, Haag v. Comr., T.C. Summ. Op. 2016-29, sheds some light on how metropolitan areas are defined for tax purposes. More specifically, the case tells taxpayers how not to define metropolitan area.

Both of the taxpayers, a married couple, were electricians and members of the International Brotherhood of Electrical Workers. They belonged to Local 150. They lived in Lake County, Illinois. Both taxpayers worked for several employers at different sites in the Chicago area, and the husband also did work in Joliet, Illinois, in Champaign, Illinois, and in Florida. Both taxpayers drove their personal vehicles to and from work. The taxpayers recorded only the miles he drove beyond Lake County, relying on conversations the husband had with other union electricians.

The IRS agreed that the husband had driven 330 miles round-trip to Champaign, Illinois, and conceded that a deduction was allowable for that mileage. The Tax Court also allowed a deduction for the cost of round-trip miles driven by the husband to Chicago Midway International Airport in connection with a trip to Florida to perform work.

The IRS argued that the other miles driven by the taxpayers were personal commuting transportation and thus not deductible. Because the IRS permits the deduction of expenses incurred in traveling to work locations outside the metropolitan area where the taxpayer lives and normally works, the taxpayers argued that the expense of driving beyond Lake County was deductible. They contended that because the jurisdiction of Local 150 was limited to Lake County, Illinois, Lake County was their metropolitan area. The Tax Court disagreed with the taxpayers. The court noted that the taxpayers usually worked in Chicago or Joliet, roughly 65 miles from their home. The Court explained, “Without suggesting the adoption of any rigid definition of the term ‘metropolitan area’ for this purpose, we conclude that Lake County and petitioners’ work sites in Chicago and Joliet fall within the Chicago metropolitan area. The distances that petitioners routinely traveled to work were not so unusually long as to justify an exception to the general rule that commuting expenses are nondeductible personal expenses.”

For most people who think about the meaning of metropolitan area, what comes to mind likely is the statistical metropolitan area defined by the Office of Management and Budget, for various purposes, including the census and resulting statistical information. A closer look at the definitions reveals that ascertaining a metropolitan area is not as simple as looking at a map. There are overlaps, gaps, and variations in boundaries. As the author of this explanation put it, “In practice, the parameters of metropolitan areas, in both official and unofficial usage, are not consistent.”

Taken narrowly, the Tax Court decision simply tells us that the jurisdictional area of the union to which a taxpayer belongs is not necessarily a metropolitan area. If it is, it’s happenstance that the union’s jurisdictional area matches a metropolitan area. The resolution of the question appears to be one that rests on the facts and circumstances of each case.